For simplicity of exposition, let us assume that there are just two countries, viz., the Home country (H) and the foreign country (F), and their currencies are on gold standard. i. A country running into a deficit BOP settles the account by exporting gold to the other country.
As a result, money supplies declines in the former economy and increases in the latter. ii. It is assumed that Quantity Theory of Money is applicable in both economies, so that an increase in money supply in the BOP surplus country results in a proportionate increase in its domestic price level. Just the opposite happens to the price level in the country having a deficit BOP. The prices fall in that country.
iii. Both countries have competitive and resilient (flexible, adjustable) economies, so that they are able to adjust their production and consumption patterns rapidly in response to changes in prices.
Under these assumptions, let H run into a deficit BOT and lose gold in favour of F. Money supply and prices will decrease in H and increase in F.
This will cause in increase in exports of H to F and a reduction in its imports from F. This process of adjustment will continue till BOT deficit of H is wiped out. Just the opposite happens when the home country (H) experiences a surplus BOT, and its currency-appreciates in the foreign exchange market.
However, for successful operation of this automatic adjustment mechanism, it is essential that: i. Each economy should be able to produce enough of each traded commodity so as to meet the combined demand from both trading countries; ii. The demand for and supply of traded goods should have sufficiently high price elasticity’s; iii.
Both economies should be able to adjust their production patterns quickly; iv. Factors like economies of scale should not operate and hinder the required changes in trade flows. B.
Under Paper Standard: There can be a regime of fixed exchange rates even when the currencies of the trading countries are on a paper standard. Further, this regime of exchange rates may or may not be supplemented with exchange control.
1. With Exchange Control:
Under this arrangement, the authorities can maintain a rigidly fixed exchange rate and defend it by regulating the sale/ purchase of foreign exchange. The authorities can pursue this policy successfully provided they are not prevented in doing so under some international obligation or pressure, and provided they are ready to accept the associated production and consumption distortions within the home economy. Under this arrangement, international payments are fully monitored and market forces are not allowed to create a persistent BOT deficit.
2. Without Exchange Control:
If the authorities do not maintain a full- fledged exchange control, and there is a persistent deficit or surplus in BOP, they will have to enter the exchange market as sellers or buyers of foreign exchange (for maintaining exchange rate at a fixed level).
The disadvantage of this arrangement is that, the rate of exchange is not allowed to play its part in adjustment and bear a part of the shock. Instead, the entire adjustment takes place through variations in the levels of employment, income and prices of the domestic economy. This is more so if the economy in question is a “small” one [that is, its transactions have no significant influence on the prices of its imports and exports]. In other words, this policy sacrifices stability of the domestic economy for ensuring stability of the exchange rate. The entire process also ignores the role of elasticity’s of demand and supply of a country’s exports and imports. Another limitation of this policy is that a long-term and persistent deficit or surplus in BOP can lead [unlike the case under gold standard] to a cumulative depletion (or replenishment) of the country’s foreign exchange reserves.
However, no country is expected to have inexhaustible foreign exchange reserves, nor is it expected to accept a limitless addition in them.